Nobel Prize for “Asymmetric Information”

Much of economic analysis assumes that markets are characterized by full information: both buyers and sellers know everything about the product they are buying or selling.

However, many markets are characterized by the fact that either the buyer or the seller has considerably more information about the product than does the person or firm on the other side of the transaction. Akerlof, Spence, and Stiglitz won the 2001 Nobel Prize for illustrating the importance of asymmetric information in various kinds of markets and situations.

(Stiglitz recently noted that it’s not that economists were unaware that people had different amounts of information, it was just thought that information asymmetries were not necessarily very important. Akerlof, Spence, and Stiglitz, showed both how and why the asymmetries mattered, as well as developed important applications of the basic idea.)

Market for lemons

George Akerlof illustrated the most famous example of asymmetric information in his 1970 paper on “The Market for Lemons”. The paper examined the market for used cars to illustrate the importance of informational asymmetries. The scenario is quite simple – the seller of a used car usually knows more about it than does the buyer. They know, for example, how well it runs on the highway, in the snow, when it’s hot outside, etc. The buyer knows relatively little. So if a seller offers to sell the car for, say, $5,000, the buyer should be suspicious, since, if the car were worth more than 5,000, the owner would not be selling it at that price. In this case, Akerlof showed, the market may break down completely.

This general idea can be used to explain many issues in many markets. Perhaps the most important market with significant asymmetric information is the market for health care. The buyer knows much more about her health and habits than does the insurance seller. For example, a company that offers a really good (but expensive) health policy will find that only the sick (or likely to be – say the smoking, sky-diving, race car drivers of the world) will buy that kind of insurance. Only those who expect to get more from the policy than they pay in premiums will be likely to purchase, meaning that the people who buy will be less healthy, and likely to make the policy unprofitable for the firm.

The consequences of asymmetric can be profound. In the extreme, markets with asymmetric information may simply cease to exist. In other cases, asymmetric information will cause the market to “behave badly” and thus create an opportunity for a government or some external organization to come in and intervene to improve the private market outcome.